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Proposals to Reform Credit-Rating Firms Falling Short

by Michael W. Stocker and Lisa Lindsley
Pensions & Investments |
The SEC's failure to prescribe appropriate internal controls leaves rule makers with little ability to hold ratings agencies accountable if they adopt weak and/or ineffective controls.

Given the power of sovereign debt ratings to rock the world markets, investors might be surprised to learn of the kid-glove treatment accorded to top credit-rating agencies under a raft of new rules proposed by the Securities and Exchange Commission.

The repercussions of decisions made by governmentally recognized credit-rating agencies - called Nationally Recognized Statistical Ratings Organizations, or NRSROs - have never been greater than in recent weeks.

After the closing of the stock market Aug. 5, Standard & Poor's announced that it had downgraded the U.S. credit rating to AA+, one notch below the sterling AAA grade held by the United States for 70 years. The following Monday, the Dow Jones industrial average sank more than 600 points, launching a period of sharply increased volatility.

Repeated downgrades of Greek sovereign debt this year have rapidly amplified an ongoing crisis of confidence in the stability of the eurozone.

Given the market's hair-trigger reaction to NRSRO ratings, you might expect that regulators would seek to strengthen radically rules governing the training of NRSRO analysts and the internal controls used by the agencies to ensure accurate and consistent ratings.

Judging by the proposed rules and rule changes issued earlier this summer, the SEC lacks the resources to impose truly significant reforms in these areas.

On Aug. 8, the SEC comment period closed on the proposed new regulations, which were issued pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act. While the hundreds of pages of proposed rules rightly focus on issues such as rating agencies' inadequate internal control structure, pervasive conflicts of interests, inconsistent application of rating symbols to financial products, and training and testing of analysts, the SEC makes little meaningful headway in these areas.

Proposed rules regarding the training and testing of credit rating analysts are especially disappointing. While the SEC would require that NRSROs adopt a periodic testing requirement for analysts to determine their knowledge of the procedures and methodologies, the new rules permit analysts with just three years of training to participate in the rating of complex financial products such as collateralized debt obligations.

Another problem area in the proposed rules concerns the conflicts of interests long seen as the driving force behind disastrous rating practices in the years leading up to the financial crisis of 2007-2008. The Dodd-Frank act includes a requirement that the SEC adopt rules to prevent "sales and marketing considerations" from influencing NRSRO ratings. Pursuant to this requirement, the SEC proposes a prohibition on NRSRO sales or marketing staff from participating in determining or monitoring a credit rating, or developing or approving procedures or methodologies used for determining the credit rating.

However, this approach is too mechanical and narrow to be effective. The proposed rule only applies to sales and marketing staff involvement in the rating process, when what is critically needed is a broader principles-based approach prohibiting any action by any rating agency employee that has the intent or effect of allowing sales and marketing considerations to inappropriately influence the rating process or undermine ratings accuracy.

Most troubling, perhaps, is the approach taken by the SEC in proposed rules intended to strengthen NRSRO internal controls governing the ratings process. The proposed rules effectively leave it to the rating agencies themselves to develop appropriate internal control structures - leaving the foxes to guard the henhouse. The SEC's failure to prescribe appropriate internal controls leaves rule makers with little ability to hold ratings agencies accountable if they adopt weak and/or ineffective controls.

Whether rating-agency practices will be successfully reformed depends in large part upon the effectiveness of the rules the SEC ultimately adopts and the commission's ability to enforce them. Current proposals to reduce funding to the SEC will only make a bad problem worse. With fewer regulatory resources, there is little hope for the kind of structural change necessary to avert future crises stemming from rating agency failures.